Chapter 15

Capital Structure Decisions:

The Basics

1
FINANCIAL LEVERAGE RATIO
■ D/A; E/A; D/E

2
 The Firm’s Capital Structure
■ Capital structure is one of the most complex areas
of financial decision making due to its
interrelationship with other financial
decision variables.
■ Poor capital structure decisions can result in a high
cost of capital, thereby lowering project NPVs and
making them more unacceptable.
■ Effective decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable
projects, thereby increasing the value of
the firm.
Types of Capital
Capital Structure Theory
■ According to finance theory, firms possess a
target capital structure that will minimize
its cost of capital[ = WACC].
■ Unfortunately, theory can not yet provide
financial mangers with a specific methodology
to help them determine what their firm’s
optimal capital structure might be.
■ Theoretically, however, a firm’s optimal
capital structure will just balance the benefits
of debt financing against its costs.
 The Optimal Capital Structure
■ In general, it is believed that the market value of a
company is maximized when the cost of capital (the
firm’s discount rate) is minimized.
■ The value of the firm can be defined algebraically
as follows: [ if WACC (= Ka ) goes down, Value goes
up]
The Optimal Capital Structure
EPS-EBIT Approach to Capital Structure

■ The EPS-EBIT approach to capital structure

involves selecting the capital structure that
maximizes EPS over the expected range of EBIT.
■ Using this approach, the emphasis is on maximizing
the owners returns (EPS = Net income/Shares
outstanding).
■ At shows the level of EBIT at which different
financing methods would provide same EPS.
EBIT- EPS Approach: Example
Assume that an organization has the following capital
structure:
12% debt Capital Taka 30 lac
Common stock [ 80,000] Taka 128lac
Total Capital Taka 158Lac

Proposed Capital Budget = Taka 40 Lac. Three options

are there to finance the capital budget: (1) 14% debt
capital, (2) 12% preferred stock, and (3) Common stock
@ Taka 160. Tax Rate = 40%; Expected EBIT = Taka
15Lac.
REQ: Find EPS under each of the methods and find the
indifference point of EBIT under method 1 and 3.
9
 Answer
M1(debt) M2(PS) M3(CS)
EBIT 1500000 1500000 1500000
-interest 360000 360000 360000
560000* 0 0
EBT 580000 1140000 1140000
-T(40%) 232000 456000 456000
EAT 348000 684000 684000
-PSD 0 480000*** 0
EARNINGS TO CS 348000 204000 684000
DIVIDED BY cs 80000 80000 [80000+25000**]
EPS Taka 4.35 2.556.51

…………………………………………………………………………………..
* 40,00000x14% = 560,000
•** Taka 40,00000 /Taka 160 = 25,000 common shares under method 3]

•*** = Taka 40,00000@12% = Taka 480,000

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Indifference point of M1 and M3

■ How to find Indifference Point?

(EBIT – I1)(1-T)/S1 = (EBIT – I3)(1-T)/S3
(EBIT – 920000)/80000 = (EBIT-360000)/105000
EBIT = 27,12000

At what EBIT two methods’ EPS would be same is known as indifference

point
S1 = Common shares under method 1
S3 = Common shares under method 3
I1 = Interest payment under method 1
I3 = Interest payment under method 3

11
 Answer

M1(debt) M3(CS)
EBIT 2712000 2712000
-interest 360000 360000
560000 0
EBT 1792000 2352000
-T(40%) 716800 940800
EAT 1075200 1411200
-PSD 0 0
EARNINGS TO CS 1075200 1411200
DIVIDED BY cs 80000 [80000+25000]
EPS 13.44 13.44

12
 EPS Indifference Point:
■ EPS Indifference Point: The level of sales
at which EPS will be the same whether the
firm uses debt or common stock financing.

13
 Determinants of Intrinsic Value:
The Capital Structure Choice

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average Firm’s

cost of capital debt/equity
(WACC) mix

Market interest rates Cost of debt

Cost of equity
Market risk aversion Firm’s business risk
14
The Effect of Additional
Debt on WACC
■ Debtholders have a prior claim on cash flows
relative to stockholders.
■ Debtholders’ “fixed” claim increases risk of
stockholders’ “residual” claim.
■ Cost of stock, rs, goes up.
■ Firm’s can deduct interest expenses.
■ Reduces the taxes paid
■ Frees up more cash for payments to investors
■ Reduces after-tax cost of debt
(Continued…)
15
The Effect on WACC
(Continued)
■ Debt increases risk of bankruptcy
■ Causes pre-tax cost of debt, rd, to increase
■ Adding debt increase percent of firm
financed with low-cost debt (wd) and
decreases percent financed with
high-cost equity (wce)
■ Net effect on WACC = uncertain.
(Continued…)
16
 The Effect of Additional Debt
on FCF
■ Additional debt increases the probability
of bankruptcy.
■ Direct costs: Legal fees, “fire” sales, etc.
■ Indirect costs: Lost customers, reduction in
productivity of managers and line workers,
reduction in credit (i.e., accounts payable)
offered by suppliers

(Continued…)
17
Asymmetric Information
and Signaling

■ Managers know the firm’s future prospects

better than investors.
■ Managers would not issue additional equity if
they thought the current stock price was less
than the true value of the stock (given their
inside information).
■ Hence, investors often perceive an additional
issuance of stock as a negative signal, and
the stock price falls.
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Factors That Influence
Business Risk
■ Uncertainty about demand (unit sales).
■ Uncertainty about output prices.
■ Uncertainty about input costs.
■ Product and other types of liability.
■ Degree of operating leverage (DOL).

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 What is operating leverage, and how
does it affect a firm’s business risk?

■ Operating leverage is the change in

EBIT caused by a change in quantity
sold.
■ The higher the proportion of fixed costs
within a firm’s overall cost structure, the
greater the operating leverage.

(More...)

20
Signaling theory:
■ Signaling theory: Issuing debt would
give a positive signal as the share price
is undervalued so it would go up in
future. Future prospect is bright. So,
issuing debt gives a positive signal.
■ Issuing New shares: Give negative
signal, future prospective is bad.

21
Higher operating leverage leads to more
business risk: small sales decline causes a
larger EBIT decline.

Rev. Rev.
$ $
TC } EBIT
TC
F
F

QBE Sales Sales

QBE
(More...)
22
Operating Breakeven
■ Q is quantity sold, F is fixed cost, V is
variable cost, TC is total cost, and P is
price per unit.
■ Operating breakeven = QBE
■ QBE = F / (P – V)
■ Example: F=$200, P=$15, and V=$10:
■ QBE = $200 / ($15 – $10) = 40.
(More...)
23
Business Risk versus Financial
Risk
■Business risk: [ it arises from the use of fixed
cost coverage. FC]
■ Uncertainty in future EBIT.
■ Depends on business factors such as
competition, operating leverage, etc.
■ Financial risk:[ it arises from the inability to pay
fixed financial coverage like paying interest payment
and preferred stock dividend]
■ Additional business risk concentrated on common

stockholders when financial leverage is used.

■ Depends on the amount of debt and preferred

stock financing.
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Consider Two Hypothetical
Firms
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate

Both firms have same operating leverage,

business risk, and EBIT of $3,000. They differ
only with respect to use of debt.
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Impact of Leverage on
Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080

ROE (=NI/SE) 9.0% 10.8%

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Why does leveraging increase
return?
■ More EBIT goes to investors in Firm L.
■ Total dollars paid to investors:
■ U: NI = $1,800.
■ L: NI + Int = $1,080 + $1,200 = $2,280.
■ Taxes paid:
■ U: $1,200; L: $720.
■ Equity $ proportionally lower than NI.

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Capital Structure Theory*
■ MM theory [ Franco Modigliani and Merton Miller]
■ Zero taxes
■ Corporate taxes
■ Corporate and personal taxes
■ Trade-off theory
■ Signaling theory
■ Pecking order
■ Debt financing as a managerial constraint
■ Windows of opportunity

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 MM Results: Zero Taxes
■ MM assume: (1) no transactions costs; (2) no
restrictions or costs to short sales; and (3)
individuals can borrow at the same rate as
corporations.
■ Under these assumptions, MM prove that if the total
CF to investors of Firm U (unlevered firm, with no
debt] and Firm L [ Levered firm with both debt and
equity] are equal, then the total values of Firm U and
Firm L must be equal:
■ V L = V U.[ value of levered firm = value of unlevered firm
. MM I without tax]
■ Because FCF and values of firms L and U are equal,
their WACCs are equal.
■ Therefore, capital structure is irrelevant.
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 MM Theory: Corporate Taxes

■ Corporate tax laws allow interest to be

deducted, which reduces taxes paid by
levered firms.
■ Therefore, more CF goes to investors and
less to taxes when leverage is used.
■ In other words, the debt “shields” some
of the firm’s CF from taxes.

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 MM Result: Corporate Taxes
■ MM show that the total CF to Firm L’s investors
is equal to the total CF to Firm U’s investor plus
an additional amount due to interest
deductibility: CFL = CFU + rdDT.
■ MM then show that: VL = VU + TD. [ MMI with
tax= value of levered firm equals the value of
unlevered firm plus Tax benefit on debt].
■ MM II: The cost of equity is a linear function of
debt to equity ratio.
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 MM relationship between value and debt
when corporate taxes are considered.
Value of Firm, V

VL
TD
VU

Debt
0

Under MM with corporate taxes, the firm’s value

increases continuously as more and more debt is used.
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Miller’s Theory: Corporate and
Personal Taxes
■ Personal taxes lessen the advantage of
corporate debt:
■ Corporate taxes favor debt financing since
corporations can deduct interest expenses.
■ Personal taxes favor equity financing, since
no gain is reported until stock is sold, and
long-term gains are taxed at a lower rate.

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Miller’s Model with Corporate
and Personal Taxes

[
VL = V U + 1 -
(1 - Td)
]
(1 - Tc)(1 - Ts)
D.
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.

34
 Tc = 40%, Td = 30%,
and Ts = 12%.

[ ]
VL = VU + 1 - (1 - 0.40)(1 - 0.12) D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in
debt raises L’s value by $0.25.
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M-M Proposition I: “A firm cannot change the
value of its capital structure by changing the
mix of debt and equity”. [ V = D +E]
M-M Proposition II: “Cost of equity is a linear
function of debt-to-equity ratio”.
Without tax: VL = Vu
With Tax : VL = Vu +TcB
[ TcB corporate tax benefit on bond or
debt]
36
Trade-off Theory
■ MM theory ignores bankruptcy (financial
distress) costs, which increase as more
leverage is used.
■ At low leverage levels, tax benefits outweigh
bankruptcy costs.
■ At high levels, bankruptcy costs outweigh tax
benefits.
■ An optimal capital structure exists that
balances these costs and benefits.

37
 Signaling Theory
■ MM assumed that investors and managers
have the same information.
■ But, managers often have better information.
Thus, they would:
■ Sell stock if stock is overvalued. [ negative signal]
■ Sell bonds if stock is undervalued.[ positive signal]
■ Investors understand this, so view new stock
sales as a negative signal.
■ Implications for managers?

38
 Pecking Order Theory
■ Firms use internally generated funds first,
because there are no flotation costs or negative
signals.
■ If more funds are needed, firms then issue debt
because it has lower flotation costs than equity and
not negative signals.
■ If more funds are needed, firms then issue equity.

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 Windows of Opportunity

■ Managers try to “time the market” when

issuing securities.
■ They issue equity when the market is “high”
and after big stock price run ups.
■ They issue debt when the stock market is
“low” and when interest rates are “low.”

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The Cost of Equity at Different Levels
of Debt: Hamada’s Equation

■ MM theory implies that beta changes

with leverage.
■ bU is the beta of a firm when it has no
debt (the unlevered beta)
■ bL = bU [1 + (1 - T)(D/S)]

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 The Cost of Equity for wd =
20%
■ Use Hamada’s equation to find beta:
bL= bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
■ Use CAPM to find the cost of equity:

rs=cost of equity = RFR + bL (Rm- RFR)

= 6% + 1.15 (6%) = 12.9%
Rm- RFR = Risk premium = 6%; Rm= 12%
42
Cost of Equity vs. Leverage
wd D/S bL rs

0% 0.00 1.000 12.00%

20% 0.25 1.150 12.90%
30% 0.43 1.257 13.54%
40% 0.67 1.400 14.40%
50% 1.00 1.600 15.60%
43
The WACC for wd = 20%
■ WACC = wd (1-T) rd + wce rs
■ WACC = 0.2 (1 – 0.4) (8%) + 0.8
(12.9%)
■ WACC = 11.28%

■ Repeat this for all capital structures

under consideration.

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WACC vs. Leverage

wd rd rs WACC
0% 0.0% 12.00% 12.00%
20% 8.0% 12.90% 11.28%
30% 8.5% 13.54% 11.01%
40% 10.0% 14.40% 11.04%
50% 12.0% 15.60% 11.40%
45
Calculating S, the Value of Equity after
the Recapitalization

■ S = (1 – wd) Vop
■ At wd = 20%:
■ S = (1 – 0.20) $2,659,574
■ S = $2,127,660.
■ Vop = Value of operations
Calculating P, the Stock Price
after the Recapitalization
P = [S + (D – D0)]/n0
P = $2,127,660 + ($531,915 – 0)
100,000
P = $26.596 per share.

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Number of Shares after a
Repurchase, n
■ # Repurchased = (D - D0) / P
■ n = n0 - (D - D0) / P
■ # Rep. = ($531,915 – 0) / $26.596
■ # Rep. = 20,000.
■ n = 100,000 – 20,000
■ n = 80,000.

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